by Robert Litan
Volcker became Fed chairman after an already highly successful financial career. He began initially as a staff economist at the Federal Reserve Bank of New York, moved to Chase Manhattan Bank, then went to the Treasury department to work under the famed Robert Roosa, who was the department’s undersecretary for international and monetary affairs. After going back to a vice-presidency at Chase, Volcker returned to Treasury from 1969 to 1974 to assume the job that Roosa had, where he played a crucial role in decisions leading to the end of the Bretton Woods era of fixed exchange rates. He thereafter made another return, to his first employer, the Federal Reserve Bank of New York, but as its president.
After leading the Fed, Volcker came back to private life as chairman of Wolfensohn and Co., a private investment and corporate advisory firm. President Obama, shortly after assuming office, asked Volcker to chair the President’s Economic Advisory Board, a body that lacked real power. It was widely reported that Volcker was frustrated as a result. The president’s adoption of the idea that Volcker was then urging—a ban on proprietary trading by banks—put Volcker back squarely in the public eye. The Volcker rule, as it has since become known, took multiple regulators over three years to implement and remains highly controversial, but its author is not. Volcker will always be a giant among professional economists.
One small personal footnote: I have had the great privilege of interacting with Volcker on professional issues over the years. I can tell you that he is warm, funny, and generous with his time. We had firm, but polite disagreements (the virtues of financial innovation being one, the wisdom of the Volcker rule being another, although I never voiced my views on this directly to him). His graciousness I will never forget.
I haven’t taken a scientific poll, nor have I seen one, but I suspect that most economists who are knowledgeable about finance do not support the Volcker rule (though there are notable exceptions, such as Simon Johnson of MIT and formerly chief economist at the International Monetary Fund). Just as the economic case for Glass–Steagall was weak or nonexistent, there was no evidence that the mixing of commercial and investment banking contributed in any significant way to the extension of subprime loans or their packaging into securities (which was accomplished by a number of standalone investment banks, having no formal connection with the banking industry). Most microeconomists also instinctively oppose artificial legal barriers to competition, which is what Glass–Steagall represented: a wall that put a protective moat around investment banks that were underwriting securities.
The implementation of the Volcker rule has not been smooth. It took over three years for five regulatory agencies to write the rules, in part because of stiff opposition from large banks that had major trading operations (which reinforced the conviction of Volcker’s advocates that the rule was necessary), and also because the apparently simple rule was difficult to operationalize. Just two examples: Despite its prohibition on proprietary trading, the rule allowed trades for hedging purposes and to facilitate market making. After much consideration, the final rule achieved more clarity with the hedging exception (essentially requiring banks to tie any specific trade for hedging purposes to the risks posed by a specific customer transaction), but regulators almost certainly will find the market-making exception difficult to enforce.
In order to meet the needs of their clients, banks (like securities firms), buy certain securities to hold in their inventory from which they sell to or buy from clients. By definition, many of these transactions anticipate orders by clients, and thus expose banks to some risk for some short period of time (much shorter than the typical maturity of a business loan). It is not clear how, even on a case-by-case basis, regulators will be able to draw defensible lines between impermissible proprietary trading and permissible market making. While banks continue to wrestle with these uncertainties, and some may abandon trading altogether, depriving customers of services and thinning liquidity in the markets in which they were once active, two groups of firms clearly will benefit from the Volcker rule: the lawyers and consultants that banks have hired to help them comply with the rule and, if necessary, contest the regulators’ ongoing interpretations of it.
To accomplish all this, the agencies took more than 70 pages of actual text (and many hundreds of pages of preamble) to explain the rule’s deceptively simple proprietary trading prohibition. My guess is that either regulators or the courts eventually will draw the bright lines about market making, and to a lesser extent, hedging that are not in the initial Volcker rule. If this process is not satisfactory to Volcker’s advocates, or if one or more large banks (or more precisely their uninsured creditors) require a bailout in a future financial crisis, the pressure for a full-scale return to Glass–Steagall (without some or all of its initial exceptions) will only grow. It is unlikely that this outcome will be supported by a majority of financial or even macroeconomists, but that is not likely to matter in the face of another political backlash against large banks. That same backlash may lead to a forced breakup of those institutions in an effort to mitigate the too-big-to-fail problem (another issue on which a consensus of economists has been difficult to assemble).
In the meantime, policy makers in the United States may be watching how European policy makers are approaching these issues. After initially flirting with something like the Volcker rule for its banks, the European Union backed off in early 2014, proposing instead that the divorce between bank lending and trading activities be handled on a case-by-case basis rather than imposed as a hard-and-fast rule (even with its blurry lines) as is now the case in the United States.31
The Bottom Line
The indirect influences of economists on the financial industry, on national economic policy, and on the businesses that make up the larger economy are a lot more beneficial than popularly believed.
Economists provided the intellectual support for ending fixed commissions, or essentially legalized price fixing, which enabled a wave of discount brokers to enter the securities industry, conferring large benefits on investors.
Two economists played an even larger role, though unexpected at the outset, in accelerating electronic exchanges for transactions in equities and other financial instruments, lowering trading costs.
Two other economists, backed by many more, established the intellectual foundation for an enforceable system of bank-capital regulation that stood the financial system and the economy as a whole in good stead for roughly 15 years before policy makers within the regulatory agencies, the executive branch, and Congress undermined it.
There is no consensus on some fundamental bank and financial regulatory issues since the financial crisis of 2007–2008. The intellectual vacuum has been filled by highly complex systems of bank capital regulation (the Basel standards) and by new restrictions on bank activities (the Volcker rule). There is some irony in this: We are left with complexity instead of simplicity. It is far from clear that this system will serve the financial industry or the economy as a whole well going forward. Count me as one skeptical economist.
Notes
1. For this history, see www.thinkadvisor.com/2010/05/01/the-great-unfixing.
2. Jeffrey A. Esienach and James C. Miller III, “Price Competition on the NYSE,” Regulation (January/February 1981): 16–19.
3. This history is based on an interview with Donald Baker, December 3, 2013.
4. Jason Zweig, “Even When Stocks Make You Nervous, Count Your Blessings,” Wall Street Journal, November 30–December 1, 2013.
5. William G. Christie and Paul H. Schultz, “Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?” The Journal of Finance 49, no. 5 (December 1994): 1813–1840.
6. Ibid., 1814.
7. For a description of the evidence supporting the consent decree, see U.S. Department of Justice, Antitrust Division, United States v. Alex. Brown & Sons Inc., et al.—Competitive Impact Statement. Washington, DC: U.S. Department of Justice, July 16, 1998, www.usdoj.gov/atr/cases/f0700/0739.htm.
8. Jeffrey Pe
rloff, “Economists Prevent Collusion,” wps.aw.com/aw_perloff_microcalc_2/149/38380/9825344.cw/content/index.html.
9. Nela Richardson and Jeffrey H. Harris, “Slowing Down High-Speed Trading,” Bloomberg Government.com, August 12, 2013 [behind paywall].
10. For an excellent and entertaining guide to dark pools, see Scott Patterson, Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market (New York: Crown Publishing, 2012).
11. Matthew Phillips, “How the Robots Lost: High-Frequency Trading’s Rise and Fall,” Bloomberg Businessweek, June 6, 2013, www.businessweek.com/articles/2013-06-06/how-the-robots-lost-high-frequency-tradings-rise-and-fall; and Financial Stability Oversight Council, Annual Report 2012, www.treasury.gov/initiatives/fsoc/Documents/annual-report.aspx.
12. Lewis, Michael, Flash Boys (New York: W.W. Norton & Co., 2014).
13. Securities and Exchange Commission, Concept Release on Equity Market Structure, 2010, www.sec.gov/rules/concept/2010/34-61358.pdf. See also Robert E. Litan and Harold Bradley, “Choking the Recovery: Why New Growth Companies Aren’t Going Public and Unrecognized Risks of Future Market Disruptions,” Ewing Marion Kauffman Foundation, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1706174.
14. Carmen M. Reinhardt and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2011).
15. Robert E. Litan, What Should Banks Do? (Washington, DC: Brookings Institution, 1987).
16. Bank failure data are from the Federal Deposit Insurance Corporation, www2.fdic.gov/hsob/HSOBRpt.asp.
17. Alan Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin Press, 2013); Sheila Bair, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself (New York: Free Press, 2012); Gillian Tett, Fool’s Gold: The Inside Story of J.P. Morgan and How Wall Street Greed Corrupted Its Bold Dream and Created a Financial Catastrophe (New York: Free Press, 2010); and Michael Lewis, The Big Short: Inside the Doomsday Machine (New York: W.W. Norton & Co., 2011).
18. National Commission on the Causes of the Financial and Economic Crisis in the United States, The Financial Crisis Inquiry Report, January 2011, http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
19. For a longer exposition of what I think about the financial crisis and the response to it, see Robert E. Litan, “The Political Economy of the Financial Crisis,” in Rethinking the Financial Crisis, ed. Alan S. Blinder, Andrew W. Lo, and Robert M. Solow (New York: Russell Sage Foundation): 269–302.
20. For an excellent summary of changing views among economists about the benefits and costs of home ownership, especially since the onset of the financial crisis, see “Shelter or Burden?” The Economist, April 16, 2009, www.economist.com/node/13491933.
21. Edward M. Gramlich, Subprime Mortgages: America’s Latest Boom and Bust (Washington, DC: Urban Institute Press, 2007).
22. See, e.g., Edmund L. Andrews, “Greenspan Concedes Error on Regulation,” New York Times, www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=0.
23. There are many academic accounts of the S&L crisis in the 1980s. Two of the better ones are Edward J. Kane, The S&L Insurance Mess; How Did It Happen? (New York: University Press of America, 1989) and Lawrence J. White, The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation (New York: Oxford University Press, 1991). I had the privilege of serving on a congressionally authorized commission on the causes of the savings and loan crisis, which issued its report, Origins and Causes of the S&L Debacle: A Blueprint for Reform, in 1993.
24. For an excellent history of SEIR, see George G. Kaufman and George J. Benston, “The Intellectual History of the Federal Deposit Insurance Corporation Improvement Act of 1991,” in Assessing Bank Reform: FDICIA One Year Later, ed. George G. Kaufman and Robert E. Litan (Washington, DC: The Brookings Institution, 1993).
25. For a thorough critique of the Basel standards, see Daniel Tarullo, Banking on Basel: The Future of International Bank Regulation (Washington, DC: The Petersen Institute of International Economics, 2008). Shortly after this book was published, Tarullo was nominated and then confirmed as a governor of the Federal Reserve Board, where his primary duties have been to oversee the Fed’s supervision of bank and financial holding companies, and the state-chartered banks belonging to the Federal Reserve System.
26. Anat Admati and Martin Hellwig, The Bankers’ New Clothes (Washington, DC: Peterson Institute for International Economics, 2013).
27. Blinder (2013).
28. See, e.g., Mark Flannery, “Economic Evaluation of Bank Securities Activities,” in Ingo Walter, ed., Deregulating Wall Street: Commercial Bank Penetration of the Corporate Securities Market (New York: John Wiley & Sons, 1985), 67–87; Thomas F. Huertas, “An Economic Brief Against Glass–Steagall,” Journal of Bank Research 14 (Autumn, 1984): 148–159; and George J. Benston, The Separation of Commercial and Investment Banking: The Glass–Steagall Act Revisited and Reconsidered (New York: Oxford University Press, 1990).
29. Litan, What Should Banks Do?
30. For a thorough account of Volcker’s life in public service, see William Silber, Volcker: The Triumph of Persistence (New York: Bloomsbury Press, 2012).
31. Alex Barker, “Europe Set to Soften Bank Split Reforms,” Financial Times, January 6, 2014.
PART III
LOOKING AHEAD
I hope the chapters up to this point have convinced you that economists and their ideas have made important contributions to the world of business and to the general economy. I now want to engage in a bit of crystal ball gazing and look ahead to additional ways that already developed economic ideas (and thus on the shelf) are waiting to be commercially exploited, either directly by entrepreneurs or established firms, or by policy makers at multiple levels of government, in which case the ideas would help establish additional platforms for many new firms to get started or existing firms to branch into new lines of business.
I necessarily have to be selective so, given my own limitations, I will stick to those ideas with which I am most familiar.
The book concludes with some ruminations on the future of the economics profession itself. Economists will continue to be important, but their field will change and possibly meld with other disciplines. Economists will continue to theorize about, participate in, and be affected by what goes in the real world and the explosion of Big Data will help them do it.
Chapter 13
Economic Ideas in Waiting: Business Applications
Economic ideas can find their ways into business applications through multiple channels: because a founder or an executive is exposed to them in college or in reading the professional literature (or from mainstream articles that summarize that literature); because a company learns of or expands on an idea from an economist whom they have hired as a consultant; or because the originator of the idea, whether or not a formally trained economist, implements it by launching a new business.
As New York Yankee Yogi Berra famously once said, “It’s tough to make predictions, especially about the future.” This aphorism couldn’t be more apt than when attempting to project which of the many possible economic ideas already out there will generate new business opportunities. But I’m going to try in this chapter by focusing on three areas where much thinking already has been done and related ideas are waiting to be commercialized. What I won’t do is attempt to predict what economic ideas not yet thought up might also have important business implications. If I could do that, I would not have spent so much time writing this book.
Prediction Markets
One of the tenets that most economists strongly hold is that markets—where people or firms are actually spending their own money—are better than opinion polls or focus groups in gauging the level of interest in any particular product or idea. For example, one can ask a lot of people what they think gross domestic product (GDP) is going to be next
year and then compute the average of the answer. If there were a market in GDP forecasts, where people could win or lose depending on the accuracy of their projections, the average of those forecasts is likely to be more on target than if people are asked to volunteer their estimates or guesses for free.
Actually, examples of such “prediction markets” are already in place. Perhaps the first example was the Iowa Electronic Market for presidential candidates, operated by the faculty at the business school at the University of Iowa since 1988.1 Individuals could and still can place limited bets on the outcome of presidential elections, with the payoff being $1 in case the chosen candidate wins, and zero otherwise. The price at any one time for each candidate is expressed in fractions of a dollar, and thus represents the market’s best estimate of the probability that the candidate will win. Iowa runs similar markets for congressional elections and for monetary policy decisions by the Federal Reserve.
Prediction markets harness the wisdom of the crowd, and often (but not always) the informed crowd, to project outcomes.2 A spirited academic literature over additional uses, design, and performance of prediction markets, both in private market and public policy settings, is reflected in peer-reviewed academic articles in the Journal of Prediction Markets.3
The enthusiasm for prediction markets seemed to be exponentially rising until two events chilled interest. In the policy sphere, prediction markets were tarnished by the exposure of their potential use by government employees as a way of forecasting the timing, location, and likelihood of terrorist attacks. The objective surely seems worthwhile; in principle, making such predictions is one reason we have intelligence agencies. But when it came to light in 2003 that the Defense Department was considering allowing investors to bet on acts of terrorism, prompt political and media condemnation quickly forced the program to shut down, and even helped lead to the resignation of Admiral John Poindexter, then head of DARPA, the Defense Department’s highly regarded research arm.4 Although a terrorism prediction market may well have done better at predicting terrorist acts than any human or satellite intelligence, there was revulsion at the notion that anyone could profit from a terrorist act. This negative attitude was reinforced in the Dodd–Frank financial reform law of 2010 that contained a little-noticed provision that also banned futures contracts related to terrorism, assassination, gaming, or anything “contrary to the public interest.”
